What is a business loan?
Cash is the lifeblood of any business, but from time to time businesses can face a shortage of the cash they need to carry out expansion plans or fund day to day operations. A business loan can make up that cash shortfall, providing the fuel required to set a business back on the road to growth.
Business loans can be one of the most common forms of finance available to business. They take the form of a lump sum of cash which is released to the business, usually by a bank, and then repaid over a fixed period of time.
Because small and medium sized businesses usually don't have access to the debt and equity markets – in other words, they can't issue bonds or stocks – business loans are much more commonly used by SMEs than by large corporates.
Business loans can be used to borrow from as little as a few thousand to over a million pounds and repayment terms can range from 6 months to ten years or more. A business loan might be unsecured, like a personal loan, or secured against some asset owned by the business or business-owner e.g. a property.
Alongside banks, business loans can be offered by specialist business finance providers and peer-to-peer lenders. Interest rates offered depend on a variety of factors including the lender, the financial health of the borrowing company, whether the loan is secured against an asset and the prevailing market conditions.
Following the financial crisis of 2007-08 business loans have been hard to obtain in the UK, despite government interventions, like the Bank of England's Funding for Lending Scheme. Conditions have eased recently but most lenders still have strict requirements for borrowers.
Businesses applying for loans therefore need to pay careful attention to these requirements and to their paperwork during the application process.
Benefits of business loans
Business loans might be taken out for a variety of reasons including, but not limited to:
- Purchase of assets like buildings, plant or equipment.
- Purchase of additional inventory to take advantage of an anticipated busy period e.g. Christmas.
- To alleviate a cashflow shortage caused by seasonal effects, business expansion or changes to the business cycle.
Business loans can offer a number of benefits to SMEs when used for business expansion. They can be arranged with a fixed rate of interest so that repayments are known and can be incorporated into business forecasting. They have fixed terms so the date when repayments end is known and they are generally cheaper than other forms of business financing.
It should be noted however that business loans should not be used to finance ongoing losses. If a business model has fundamental problems then those problems should be addressed before seeking finance – the interest costs of a loan can merely exacerbate them.
Types of business loan
Two common types of business loans are short term loans and medium-long term loans.
Short Term Loans
These loans are typically offered over a period of 6 to 24 months and can be secured or unsecured. As well as the standard fixed rate loan (where you repay the same amount each month) there are also two other forms of short term loan available: revenue advance loans and revolving credit loans.
Revenue Advance Loans
With these loans you repay a set percentage of your sales revenue until the agreed-upon amount is repaid. A benefit of such loans is that the interests of lender and borrower are aligned – the loan gets repaid quicker the faster the business grows.
Revolving Credit Loans
Here the borrower has access to a set amount of credit over an agreed period. The borrower can draw down as much or as little of the loan as needed and only pays interest on that portion of the loan. There are potential benefits for businesses whose borrowing requirements are variable but the interest rates charged are higher than with an equivalent fixed rate loan.
Medium-Long Term Loans
These are typically fixed-rate loans which are often paid back over 1 to 10 years. An advantage of paying back a loan over a longer period is that monthly or quarterly repayments are lower. The trade off here of course is that over the life of the loan the total cost of borrowing is higher than with a short term loan.
Providers of business loans
Business loans generally only used to be provided by the major high street banks but in the past few years many non-bank lenders have entered into the marketplace with offerings that are different to traditional bank loans.
Many of the major high street banks still offer business loans though most don't market them very aggressively. RBS, and its subsidiary NatWest, are among the few actively touting small business loans (for companies with turnover up to £2m) of £1,000 to £25,000 at a fixed rate of interest over a term of 1 to 10 years. They don't charge arrangement fees.
HSBC offer fixed and variable rate small business loans (for companies with turnover up to £6.5m), again ranging from £1,000 to £25,000 over 1 to 10 years. Repayment can be deferred for up to 3 months from the loan start date. They charge an arrangement fee of £100.
Lloyds Bank claim to approve 80% of loan and overdraft applications. They offer small business loans (companies with turnover up to £1m) at fixed and variable rates from £1,000 to £500,000 over 1 to 25 years. They are currently free of arrangement fees and some loans offer capital repayment holidays.
Banks will generally charge fees for early repayment of fixed rate business loans. They also might insist on security for the loan in the form of a personal guarantee (or director's guarantee).
This guarantee makes the directors responsible for repaying the loan in the event that the business is unable to repay, effectively waiving the protection available under limited liability.
Several specialist business finance companies have emerged recently offering products which differentiate these lenders from the high street banks.
Rather than offering vanilla fixed rate loans, companies such as Ortus Business Finance offer new and established businesses fixed, deferred and stepped repayment loans (where repayments increase over the life of the loan). For secured loans, amounts of between £25,500 and £1,000,000 are offered. For unsecured loans, amounts between £1,000 to £50,000 are offered.The re-payment periods for unsecured loans are up to 5 years. Re-payment periods for secured loans can be up to 10 years.
Fleximize offer Flexible business loans of between £1,000 – £200,000 and Alterium business loans from £200,000 – £1,000,000 for established businesses.
Iwoca offers revolving credit facilities (see above) of between £1,000 and £100,000 dependent on the monthly revenue of the business. Facilities last for 1 to 12 months.
Peer to Peer Lenders
This means that their rates are often lower than equivalent bank loans and that there are usually no fees for repaying loans early. Typically we observed that P2P lenders offer business loans of £5k to £1,000,000 at a fixed rate of interest over a period of 3 months to 5 years.
Typical business loan interest rates
The interest rates offered by all of the above lenders vary based on a number of factors including their assessment of the financial health of the borrowing company, the credit history of the directors, and whether the loan is secured against an asset or personally guaranteed by one or more of the directors.
In general, interest rates are also heavily dependent on the prevailing market conditions at the time or, in other words, the current Bank of England Base Rate and interbank lending rates (e.g. LIBOR). Banks offer both fixed rate loans and variable rate loans to businesses whereas non-bank lenders tend to offer just fixed rate loans.
Fixed Interest Rate Business Loans
With fixed interest rate loans the interest rate paid on the outstanding balance of the loan remains constant for the life of the loan. Since the Bank of England Base Rate (the rate at which banks borrow from the BoE) is at an historical low, there is little chance that rates will fall over the next few years.
Alternatives to business loans
There are a number of ways in which businesses can borrow finance without taking out a business loan.
Business Overdraft Facility
Business overdrafts work the same way as personal overdraft facilities with one important difference – rather than a single rate which applies to all borrowers, the bank will charge interest at a rate which depends on the business, as with a loan.This interest rate also often varies with the Bank of England Base Rate or LIBOR. Banks can also frequently charge arrangement fees for overdraft facilities and overdrafts often need to be renewed annually.
Business Credit Cards
Credit cards are useful for businesses not only as a line of credit but to make spending both easier and more accountable. There is usually an annual fee for each credit card issued.
Cards operate in the same way for businesses as for consumers: interest free periods are available but interest rates tend to be much higher than rates on business loans. Rates of 20%+ APR can be common. Therefore, we believe that they can't really be classed as a true alternative.
Another form of alternative finance that has grown in popularity is cashflow finance, also known as invoice finance. This allows a company to borrow money from a bank (e.g. Barclays or BNP Paribas), or a specialist cashflow finance company, using the company's unpaid invoices as collateral.
Two forms of invoice finance in the UK are factoring and discounting. Invoice factoring involves the finance company taking over the borrower's sales ledger and collecting debts on their behalf. Invoice discounting sees the borrower remain in control of their sales ledger, paying the income to the finance company as it comes in.
Private Equity/Venture Capital
Both private equity and venture capital can be routes to securing cash to grow your business. Typically the cost of such cash is high when compared with bank loans and involves surrendering equity in the business.
On the other hand it can be the only route for securing very large sums and often comes with financial, legal and business expertise that can be invaluable for making the transition from SME to large business.
Government Grants and Schemes
The UK government funds a number of schemes which provide finance for startups and small to medium sized businesses. These can help businesses clear many of the hurdles to acquiring finance by, for example, providing a government guarantee for business loans. A tool on the government website allows businesses to search for suitable schemes.
How to get a business loan
Applying for a business loan is a process that should be approached carefully and methodically. The stringent conditions that can be insisted upon by banks mean that accurate paperwork is a must. It should also be borne in mind that unsuccessful applications can have a deleterious effect on a person's credit score.
Before applying, a potential applicant should make a thorough survey of the deals available to them. Getting quotes from lenders is possible without going through the full application process and so borrowers should obtain a variety of quotes to compare.
Small business owners might also consider enlisting the help of an Independent Financial Adviser.
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